Unlike the CAPM, which assume markets are perfectly efficient, APT assumes markets sometimes misprice securities, before the market eventually corrects and securities move back to fair value.

Unlike the CAPM, the APT, however, does not itself reveal the identity of its priced factors - the number and nature of these factors is likely to change over time and between economies.

Finding and listing all factors can be a difficult task and runs a risk of some or the other factor being ignored.

However, this is not a risk-free operation in the classic sense of arbitragebecause investors are assuming that the model is correct and making directional tradesâ€”rather than locking in risk-free profits. Mechanics[ edit ] In the APT context, arbitrage consists of trading in two assets â€” with at least one being mispriced.

The question is how to interpret this last term. Thus, factor shocks would cause structural changes in assets' expected returns, or in the case of stocks, in firms' profitabilities.

Then i the return on any given asset f with payoffs can be expressed as a linear combination of returns on the n fundamental assets, i. So, the expected return is calculated taking into account various factors and their sensitivities that might affect the stock price movement.

Several a priori guidelines as to the characteristics required of potential factors are, however, suggested: their impact on asset prices manifests in their unexpected movements they should represent undiversifiable influences these are, clearly, more likely to be macroeconomic rather than firm-specific in nature timely and accurate information on these variables is required the relationship should be theoretically justifiable on economic grounds Chen, Roll and Ross identified the following macro-economic factors as significant in explaining security returns: surprises in GNP as indicated by an industrial production index; surprises in investor confidence due to changes in default premium in corporate bonds; surprise shifts in the yield curve.

In some ways, the CAPM can be considered a "special case" of the APT in that the securities market line represents a single-factor model of the asset price, where beta is exposed to changes in value of the market.

Thus, it allows the selection of factors that affect the stock price largely and specifically. Let us now look at some arbitrage pricing theory advantages and disadvantages summarized as under: Arbitrage Pricing Theory Benefits APT model is a multi-factor model.

Let us now define the financial return of asset f in state s, Rfs, as the value of the payoff divided by the purchasing price minus 1, i.

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Arbitrage pricing theory